What Comes Next for Merger Accounting

Any time now, we are expecting both the Financial Accounting Standards Board and its global counterpart, the International Accounting Standards Board, to issue final standards on accounting for business combinations and non-controlling interests.

These standards are the culmination of a joint project between FASB and IASB, and staffs of both boards have participated on the project team since it was added to their agendas in 2002. In fact, the business combinations project was part of the now-famous Memorandum of Understanding that outlined the “Roadmap of Convergence” between International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles to occur by 2009.

The purpose of the roadmap, as many Compliance Week readers know, is to remove the need for the reconciliation requirement for non-U.S. companies that use IFRS and are registered in the United States. (Of course, the roadmap may become moot should the Securities and Exchange Commission decide to allow foreign registrants to use IFRS without reconciliation to U.S. GAAP, regardless of how much progress has been made toward convergence.)

The goal of the project, as originally communicated, was to develop a single high-quality standard of accounting for business combinations for both FASB and IASB. The goal was to develop a standard that includes a common set of principles and related guidance that produces decision-useful information and minimizes exceptions to those principles. That is, the intention was to issue converged standards. Business combinations were selected as the topic for the first joint project because it was an area where a level playing field was desirable.

So what should we expect from the new standards? In general, the standards expected to be issued by FASB and IASB will be similar, but not completely converged.

More Complexity, Fair Value

FASB is expected to issue both Financial Accounting Standard No. 141R, Business Combinations (which is a revision of FAS 141, Accounting for Business Combinations) and FAS 160, Accounting for Noncontrolling Interests. These standards introduce new accounting concepts and added complexity in accounting for business combinations. FASB, however, would surely argue that the standards add simplicity to accounting for business combinations. That’s because the principle will generally instruct accountants to account for everything at fair value. Indeed, FAS 141R is the latest standard to be issued that continues the move toward greater fair value accounting. FAS 160 will significantly change the accounting and disclosure for transactions with minority-interest holders.

Every business combination will be required to be accounted for by applying the “acquisition method,” which is the new name for the “purchase accounting method.” Using this method means that the acquirer needs to be identified and the acquisition date determined (the date that the acquirer gains control, usually the closing date). In addition, the identifiable assets, acquired liabilities assumed, and any non-controlling interest in the acquired company and goodwill will need to be recognized and measured.

There are many changes that the new standards introduce. Most of the change to current practice relates to the recognition and measurement of the assets, liabilities and non-controlling interest, and the measurement of the consideration. For example, most assets and liabilities will be recognized and measured at their fair value at the acquisition date. As a result, the interplay with FAS 157, Fair Value Measurements, will be very important here.

One major change from FAS 141 is the treatment of contingent consideration and contingencies. Any contingent consideration—whether contractual or non-contractual—will be recognized at the acquisition date at its acquisition-date fair value. Changes to the acquisition-date fair value are subsequently recognized in earnings. This means that contingent consideration will need to be recorded at fair value, using FAS 157, at the acquisition date.

Are you following all this?

Well, we’re not done. Non-contractual contingencies that are recognized at, and subsequent to, the acquisition date (in other words, they meet the “more likely than not” recognition threshold) would be measured at fair value. Non-contractual contingencies not recognized at the acquisition date (those that do not meet the “more likely than not” recognition threshold at the acquisition date) will be accounted for post-acquisition in accordance with FAS 5, Accounting for Contingencies.

Lost yet? The changes are confusing, and they are profound. In fact, one might ask whether these types of changes would have been part of the Conceptual Framework project? (More on that below.) But let me add that FASB has added a project to take another look at FAS 5. Similarly, IASB is working on an amendment to International Accounting Standard No. 37 on contingencies. So, it is likely that FAS 141R will change the accounting for contingencies, and then be used as a model as both boards review the topic generally. Will this treatment better inform investors, as the post-acquisition results would be continuously affected by changes in the status and ultimate resolution of contingencies?

With respect to non-controlling interests, FASB decided to require that non-controlling interests be measured at fair value. For partial and step acquisitions, the acquiree’s identifiable assets, liabilities, and any non-controlling interest would be measured and recognized at 100 percent of their acquisition fair values. IASB agreed to permit an acquirer to measure non-controlling interests at fair value or at its proportionate interest in the acquiree’s identifiable net assets on an acquisition-by-acquisition basis.

Addressing Fundamental Issues

As alluded to above, I believe that the scope of this project should have focused only on real convergence issues. Several fundamental issues should have been addressed in the Conceptual Framework project first, as they represent major changes to the accounting model. These include the change from the parent company view of the reporting entity to the economic unit view (non-controlling interests, financial statement display, and step acquisitions); the recognition and measurement principles for contingencies (including the marking to fair value of contingencies and contingent consideration through earnings, post-acquisition); and the fact that R&D activities will now be accounted for differently depending on how they were acquired.

These changes represent huge shifts in the accounting model, and will have implications on how the Conceptual Framework project develops. In other words, the boards have put the cart before the horse.

In addition, I haven’t heard users of financial statements clamoring for these fundamental changes. Based on my read of the related comment letters received by FASB, there is no broad-based support of these changes from the various constituencies. It would seem to me that the boards should have provided detailed and supportable evidence that changes of this magnitude will significantly add value to financial reporting before they were introduced. I expect that as executives, auditors, and financial statement users become familiar with the new standards, the reaction by both companies and the investment community will not be positive.

Non-converged Standards

This is the first joint project on which the boards have embarked that has resulted in final standards. Unfortunately, the standards expected to be issued by FASB and IASB will not be converged. In fact, they are expected to differ in several areas.

To begin with, while the standards’ measurement attribute is fair value, U.S. GAAP and IFRS currently differ in the basic definition of fair value. U.S. GAAP follows the principles of FAS 157, while IFRS currently uses IFRS 3, Business Combinations. IASB is currently in the midst of a project on fair value measurements and has used FAS 157 as a starting point; but it remains to be seen whether or not they will “converge” with FAS 157.

The changes are confusing, and they are profound … In addition, I haven’t heard users of financial statements clamoring for these fundamental changes.

Tax uncertainties is another area not expected to converge yet. Again, IASB is looking at the accounting for taxes as a separate project with a goal of convergence with GAAP. The effective dates are also expected to be different—FASB is likely to require the standards to be effective with the first annual reporting period beginning after Dec. 15, 2008 (or 2009 for fiscal-year-end companies), while IASB is expected to require effectiveness for the first annual reporting period beginning after Jan. 1, 2009 (or 2010 for fiscal-year-end companies).

The boards also did not reach convergence on the measurement of non-controlling interests in a business combination. FASB determined that non-controlling interests are measured at fair value at the acquisition date. However, IASB decided to permit an acquirer to measure non-controlling interests at fair value or its proportionate interest in the acquiree’s identifiable net assets on an acquisition-by-acquisition basis.

Frankly, this is the area where I am most disturbed that convergence could not be reached. It would seem to me that, since the expected treatment required by FASB is so dramatically different from current practice, the Board would have not set itself up for criticism by not converging with IASB.

So what does it mean for the future of convergence when the boards could not agree on a converged standard? In my opinion, it’s certainly not a great first step. Given that the Securities and Exchange Commission is moving quickly on the elimination of the reconciliation requirement—and that FASB and IASB chairs have indicated their support to let the convergence project continue and evolve before we allow for choices—it would seem to me that the boards would have a much greater interest in ensuring that their first standard out of the gate was converged.

Unfortunately, they did not, and there appears to be no sense of urgency here. I can only hope that the next stop on the convergence roadmap is plotted more accurately.